While the slow normalization of central bank policy continues to be an overarching theme, the introduction of new methods to achieve this—balance-sheet reduction by the Fed, for example, and a tapering of asset purchases by the ECB—could reintroduce volatility into what are now placid markets.
We are negatively biased toward rates markets across much of the developed world, with a particularly downbeat view on the U.S., core Europe, the U.K. and Japan. However, yields on bonds in Europe’s periphery—from the likes of Greece, Ireland and Spain—offer attractive spreads relative to core issuers in an improving macro environment. Inflation-linked bonds, too, are appealing given the ongoing inability of central banks to meet their inflation targets. With little on the near-term horizon to disrupt the credit cycle, we are constructive on U.S. investment grade credit and most securitized assets, especially non-agency ABS, where demand remains strong as supply continues to shrink. With emerging market fundamentals continuing to improve, our outlook is positive across the EMD complex, with a bias toward hard-currency sovereigns. Our outlook for a variety of currencies, meanwhile, has dimmed as most appear fair to overvalued.
More detail on individual sectors is provided in the text that follow.
Global Rates and Inflation: After a brief pause in the third quarter—one that may potentially extend through the fourth—the slow unwind of global central bank accommodation should soon resume. Despite relatively positive economic momentum worldwide, realized inflation in many countries continues to disappoint. Wage growth has failed to accelerate in the face of continued labor market strength, a puzzle that will take some time to be solved.
In the U.S., inflation data perked up in August after a string of disappointments, and we expect a modest acceleration during the fourth quarter and into early 2018, as the dollar weakness that has persisted throughout 2017 is expected to boost inflation by 0.5% versus trend over the next few quarters. Dollar weakness also is expected to lift corporate profits and help prolong the current business cycle, even as the various reforms promised by the Trump administration have failed to materialize.
Balance sheet reduction by the Fed and a slower pace of asset accumulation by the ECB are new policy elements that could shift yield curve slopes and potentially reintroduce volatility to the capital markets in 2018. While market expectations for the Fed hiking cycle have become pretty benign, there still remains plenty of room for disappointment, as financial conditions today are more accommodative than they were a year ago despite three hikes by the FOMC in that timeframe.
Credit: After remaining strong through July, investment grade spreads weakened on geopolitical concerns, uncertainty around the Trump administration’s legislative agenda and tepid inflation data that weighed on interest rates. Market technicals also pressured spreads, as supply was heavy throughout the third quarter; technical pressures should abate, however, with very little issuance expected from M&A transactions in the fourth quarter. The rising leverage exhibited in the investment grade credit market over the past five years has moderated of late, thanks to the recovery in commodities and a generally less-aggressive use of corporate balance sheets, and we expect leverage to remain stable at this point.
Beyond the issues mentioned above, the market remains focused on the reduction of global central bank stimulus. A decline in liquidity—via increased benchmark policy rates, reduced asset purchases and smaller balance sheets—could increase spread volatility, which generally has been lacking for more than a year. Ultimately, however, a potential turn in the economic cycle remains the key risk to credit spreads; without any imbalances to disrupt the economy, growth should remain low but persistent and the credit cycle should continue.
Despite some recent widening, spreads on euro- and sterling-denominated credit remain near historic tights. Credit fundamentals for both non-financials and financials across the euro zone have improved along with the economic backdrop during 2017; though inflation remains sluggish, the region’s 2.3% annualized GDP growth in the second quarter represented the best result in more than two years. The U.K. continues to lag behind its Continental brethren, however, as the prospect of Brexit weighs on investment and consumer spending. Brexit also remains a concern for sterling credit, one that is likely to last beyond 2019 when the U.K. exits the European Union. With the ECB poised to temper its quantitative easing efforts, the biggest concern for euro credit is the extent and speed of tapering, though we expect the central bank’s approach to be measured. Nonetheless, at current spread levels, we remain relatively defensive on European credit; however, there continue to be some interesting security-selection ideas, particularly in corporate hybrids, which we believe are significantly undervalued relative to other European credit opportunities.
Securitized Assets: The agency MBS market continues to await the advent of Fed balance-sheet reduction, which is slated to begin in October. The general view is that the initial plan laid out by the Fed—which features an initial reinvestment reduction cap on agency MBS of $4 billion per month that gradually increases to $20 billion per month—would not be disruptive to the mortgage market, probably causing only modest widening in MBS spreads.
The mortgage credit risk transfer market began the third quarter with strong demand, as strength in the U.S. housing market brought out buyers and drove spreads about 50 basis points tighter in the process. However, hurricanes Harvey and Irma triggered questions—many of which remain unanswered—about the impact potentially catastrophic losses would have on the credit structure of these securities, pushing spreads significantly wider. While CMBS spreads were fairly stable throughout the third quarter, they, too, were impacted by Harvey and Irma, as investors remain concerned about the effect on commercial real estate values in the afflicted areas.
The legacy non-agency RMBS market continues to be extremely well bid; sourcing bonds has become increasingly difficult as the market continues to shrink, a trend we expect to continue. ABS demand remained strong as the Libor curve continued to trade at elevated levels to the short part of the Treasury yield curve, and these securities generally present good relative value.
High Yield and Leveraged Loans: The U.S. economy picked up pace in the second quarter, consistent with the recent uptick in momentum we’ve seen across developed and emerging economies. U.S. GDP growth came in at 3.0%—its first print at or above 3% in more than two years—compared with the first quarter’s 1.2% rate. The Fed has indicated it plans to continue along its measured path to policy normalization, in terms of both rate hikes and balance-sheet reduction measures. This is a constructive scenario for high yield bonds and senior floating rate loans, which historically have performed well during rising-rate environments.
We continue to believe that the high yield market is compensating investors for default risk. We think defaults peaked in 2016 and could remain below 2% in both 2017 and 2018 as revenue and leverage ratios improve. While volatility has failed to emerge in the non-investment grade space, as it has in most risk markets, the potential remains for a spike over the balance of the year given ongoing policy uncertainty in the U.S., various geopolitical flashpoints and the possibility that the improvement in global economic growth could wane.
Senior loan performance year to date has come in at the low end of our expectations, as Libor increases have not been enough to offset the spread compression in new issues that have resulted from refinancings in a high-demand environment. However, the loan market also appears to be compensating investors for default risk, and the asset class remains a low-volatility, low-risk way to gain exposure to the non-investment grade space.
We believe European high yield securities are likely to provide coupon-driven returns for the remainder of 2017. The economic outlook in Europe continues to improve, while inflation persists below trend. Though the prospect for ECB rate hikes remains low, we expect the central bank to soon begin signaling its intention to trim its quantitative easing efforts, with tapering starting as soon as January 2018. Issuer fundamentals, meanwhile, remain solid. The European high yield market carries an average rating of BB-, with company managements focused on refinancing their capital structures with lower-yielding debt. Default rates remain near historical low levels around 1% thanks in part to limited exposure to energy issuers.
Emerging Markets Debt: The post-U.S. election rebound in emerging markets assets has continued, and we remain positive on emerging markets debt going forward. Economic growth in emerging markets surprised to the upside in the first half of the year, and we expect it to remain strong. External vulnerabilities for these economies remain at multiyear lows, and several countries, having adjusted to lower commodity prices, are now in a position to rebuild FX reserves and ease monetary policy. We continue to see improving fundamentals in core countries like Brazil, Russia and Indonesia, and believe strong global growth should support exports going forward.
While yields generally have been tightening this year, valuations in emerging markets debt are still reasonably attractive in our view. In local-currency debt, real yields remain high thanks to historically low inflation levels, and we believe currencies are undervalued relative to their improved fundamentals. Local rates should be supported in the second half of the year, particularly in high-yielding countries in which inflation is expected to ease. In local currency, we prefer duration in countries with higher yields, avoiding the lower-yielding proxies of the developed world. In EM FX, we’re overweight across regions but mostly favor currencies in Europe. In hard-currency markets, our high-conviction country biases include the improving stories of Argentina and Ukraine; attractively valued opportunities in Azerbaijan, Mexico and Indonesia; and select frontier prospects, including Ivory Coast, El Salvador and Nigeria.
The key risks to emerging markets debt emanate from China and the developed markets. China’s economic activity is expected to slow somewhat going into year-end as policymakers pull back some degree of monetary stimulus. The removal of central bank support and its impact on global growth is also a concern in the developed markets, as the Fed prepares to reduce the size of its balance sheet amid its ongoing rate-hike cycle while the ECB appears poised to begin tapering its quantitative easing efforts.
Municipal Bonds: Sentiment toward the muni market has continued to improve in 2017 after the bonds sold off broadly post the U.S. elections, with fund flows sharply positive across investment grade and high yield paper. Munis have exhibited strong relative performance this year, driven by technical factors. Demand has increased as fears have waned that tax reform would reduce the appeal of munis; supply, meanwhile, has failed to keep up with last year’s record pace thanks to a decline in refunding activity. This technical backdrop remains supportive going into year end, even as high fixed costs and sluggish early-year economic growth made for a challenging budgetary season. That said, both investment grade and high yield muni bonds are more fully valued at this point.
Hurricanes Harvey and Irma underscore the liquidity risks that natural disasters can pose to the muni bond market. Although they can create significant headline risk and suppress economic activity initially, natural disasters are often followed by a period of above-average growth as federal money flows in and rebuilding efforts take hold. Careful analysis of population and tax-base size are critical factors in assessing the potential impact of ruinous events like these.
U.S. dollar: While the U.S. dollar is the worst performing major currency since the start of the year, we are constructive on the greenback. Yield differentials support a higher dollar from a medium-term perspective, and data on the real economy remain strong. Moreover, the Fed’s ongoing removal of monetary accommodation should be another positive for the currency.
Euro: While the euro’s valuation doesn’t appear stretched from a long-term perspective, the currency has appreciated too far, too fast relative to yield differentials and ECB policy to be appealing from a medium-term tactical perspective. Further, the ECB has been explicit that any further appreciation of the euro would be of concern, potentially delaying the wind-down of its asset-purchase program.
Yen: We believe the yen is undervalued from a long-term fundamental perspective. Despite continued struggles to generate inflation, data on the real Japanese economy have been strong. Moreover, the yen remains a valid hedge should there be any escalation in already-high geopolitical tensions.
Pound: The British pound is significantly undervalued from a long-term fundamental perspective. Short-term dynamics are also supportive of a stronger pound, as continued positive cross-border M&A flows and above-target inflation has inspired the Bank of England to discuss the removal of monetary accommodation.
Canadian dollar: The Canadian dollar appears to be on an upswing. Economic data have been very strong in Canada, prompting the Bank of Canada to hike its benchmark rate 25 basis points in both July and September, which suggests that it may be at the beginning of a hiking cycle.
Norwegian krone: The Norwegian krone’s appreciation has removed much of the dislocation we had identified between the currency and Norway’s positive fundamental economic outlook. Though we remain upbeat on Norway’s economy, the krone’s significant appreciation alongside uncertainties over terms of trade suggest a neutral position in the currency.
Australian dollar: The Australian dollar appears significantly overvalued from a long-term fundamental perspective. Moreover, Australia is struggling with low wage growth. A pickup in volatility from current low levels would be negative for the Australian dollar, which is one of the highest-yielding major currencies.
New Zealand dollar: The New Zealand dollar’s performance thus far in 2017 has outpaced only the U.S. dollar among major currencies. Growth is strong and well diversified in New Zealand, and dairy prices are boosting the country’s terms of trade. Moreover, the New Zealand dollar benefits from the highest carry among G10 currencies.
Swedish krona: As with the Norwegian krone, the Swedish krona’s appreciation has brought it more in line with Sweden’s upbeat fundamental economic outlook. From a short-term tactical perspective, risk-reward favors being underweight the krona as the Riksbank is likely to push back against recent currency strength.
Swiss franc: The Swiss franc continues to appear significantly overvalued from a long-term fundamental perspective. Moreover, the franc is one of the most attractive funding currencies in the world, and the central bank has made it clear that, given the strength of the franc, it would be willing to intervene to mitigate any rapid appreciation.